How the big players time the market

Active traders should rebalance their portfolios quarterly, or more often if the markets are moving significantly, says Stephane Rochon, vice-president and managing director of BMO Nesbitt Burns Inc.

Michelle Siu/The Globe and Mail

PAUL BRENT

Special to The Globe and Mail

March 26, 2017October 4, 2012

For most of us, there is a category of chores we could call "should be doing, but don't do often enough." It includes flossing, changing the oil in the car and cleaning out the garage.

For busy investors, the chore list is topped by portfolio rebalancing. A recent survey of U.S. investors by Charles Schwab found that just 11 per cent of Americans planned to rebalance their retirement portfolios over the next six months. By not updating their holdings, Schwab pointed out, they were potentially increasing the risk in their portfolios.

So just how often should active traders on this side of the border rebalance? On a quarterly basis, said Stephane Rochon, vice-president and managing director of BMO Nesbitt Burns Inc.

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And more often if markets have moved significantly, or strong macro trends are at work. When the U.S. Federal Reserve chairman or some previously unknown European bureaucrat rate front page news, that's likely a tipoff that macro factors are moving markets.

That is exactly the situation today, said Mr. Rochon, and investors should take notice. The Fed's third-quarter monetary policy (and its equivalent in Europe and China) is raising inflation expectations and will give central banks less control of the long end of the bond yield curve.

"Over the next year, maybe 18 months, we will start seeing some upward pressure on the long end of the curve and that has huge implications from an asset perspective," he said.

If interest rates rise according to BMO Nesbitt Burns's scenario, bonds will lose value and interest-rate sensitive (defensive) equities such as pipelines, REITs and telecom stocks will likely underperform.

"What people have to look at right now is the fact that early economic momentum indicators ... seem to have either troughed or are picking up slightly in the major economic regions of the world," Mr. Rochon said. That positive data signals that some of the more cyclical sectors are poised to do well.

How that translates into asset allocation for a "balanced investor" in BMO's scenario is 5 per cent cash, 35 per cent fixed income (compared with a usual benchmark weight of 45 per cent) and 60 per cent equities (compared with the usual 50 per cent).

Within equities, the investment firm recommends a weighting of 25 per cent Canadian stocks but is advising 30 per cent U.S. equities, double the benchmark weighting. "That is our big bet," Mr. Rochon said. "We are telling our clients that over the next few years you need to be allocating more money toward the U.S. because it is a more balanced market and should provide more dividend growth."

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Successful investors need to worry about more than simple asset allocation, said Jeffrey Saut, the Florida-based managing director of investment strategy and chief investment strategist for Raymond James & Associates.

"It is not just portfolio rebalancing," Mr. Saut said. Investors are reluctant to cut their losses and sell losing stocks, holding on in the often vain hope that prices will turn around. "People won't sell their losers quickly enough.

"If you manage the downside the upside will take care of itself. Avoid the big loss," Mr. Saut added. "It is the hardest thing to get retail investors especially to do. Professionals are at least somewhat good at it. And if something goes up really big, sell 20 per cent of it and see what it feels like."

While Mr. Saut's homespun investing wisdom may strike a chord with investors requiring a prod to re-examine their portfolios, the chart and data-heavy approach of Peter Gibson, CIBC's top-ranked head of portfolio strategy and quantitative research, provides both a guide to portfolio balancing and market timing.

The basis of CIBC`s asset allocation strategy is deceptively simple. Since 1998, every time bond yields fall, stock prices fall, and every time bond yields rise, in general, stock prices also rise in lockstep. What CIBC tries to do is predict the ceilings for the 10-year U.S. treasury bonds.

"The bond yield ceiling right now is 3.65 [per cent]," Mr. Gibson said. "If the bonds were to rise to that level then the stock market becomes overvalued and then we have to switch our exposure back into bonds."

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CIBC used this analysis to detect and act upon a buy signal for equities in 1998, a sell signal at the beginning of 2000 during "the peak of the tech mania," a buy signal in October, 2002, and a sell signal again in June, 2007. CIBC also sent out a buy signal in January of 2009, but "we were a little bit early," he said.

What's important about the years 2000 and 2007, when the markets crashed, "was that at the same time we were hitting the ceiling for bond yields, suggesting that bond yields are too competitive with stocks. We also have falling profitability because the Fed is tightening, trying to stop the bond yield from rising," Mr. Gibson explained.

"So the return on investment begins to fall, meaning bond yields are too competitive and corporate profitability is falling," he said. "You have no business being in the stock market."

The result was two stock market collapses of roughly 50 per cent. Meanwhile, because bond yields were falling, bond prices rose and bond total returns rose 37 per cent while the market fell 50 per cent. In 2007-2008, the bond total return was up 20 per cent while the stock market was down 57 per cent.

"This is how we time the market," Mr. Gibson explained.

"By switching just five times, from 1998 to 2009 – stocks, bonds, stocks, bonds, stocks – you are doing almost an 18 per cent per-annum return" in Canada, with a rotating split between 100 per cent stocks and 100 per cent bonds, Mr. Gibson said. "Basically you could play golf the rest of the time. It is because first and foremost you have this positive correlation between bond yields and stock prices."

Stock picking is less important with this strategy, given that 60 per cent of a total return from individual stocks is a function of the market rising or falling, not a stock`s fundamentals, CIBC states.

Today, CIBC's data shows "right now the stock market is incredibly cheap, based on the level of interest rates," he said, and CIBC is recommending that investors should be overweight in stocks.

CIBC had noticed in recent months that corporate profitability was beginning to fall and predicted (rightly) that a co-ordinated program of quantitative easing would occur in the Europe, China and the United States.

"That is what has lifted this market," Mr. Gibson said. "It is due to a policy shift, though. It is not due to strong and sustainable profit growth. If I had sustainable profit growth with the interest rate picture that I have, I would probably be talking about 1700 on the S&P."

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